Sunday, April 27, 2014

FOMC Week, by Tim Duy: The FOMC will wrap up a two-day meeting this Wednesday. I suspect the subsequent statement will be met with little fanfare. There simply has been little in the way of data to prompt any new policy path. Steady as she goes.

To be sure, the Fed will be greeted by the Q1 GDP report Wednesday morning, and it is widely expected to be very weak. But incoming data (retail sales, auto sales, industrial production, and employment, for example) suggests that much of this weakness was weather related while the underlying pace of activity, albeit arguably unexciting, remains unchanged. In short, the economy is evolving largely according to the Fed's script, and thus we should expect no major policy change. I anticipate the statement will reflect a greater confidence that the first quarter growth hiccup was a weather effect, that low inflation remains a concern, and a reiteration of the Fed's commitment to a low-rate policy path as long as inflation remains a concern. And another $10 billion cut in asset purchases to push the taper further along.

The Fed may identify housing as an area of concern. Indeed, the recent softening of that sector appears unrelated to the weather. Instead, a variety of issues are at play - higher housing prices in many areas, tight underwriting conditions, insufficient job growth, low wages relative to home prices, uncertainty about the financial benefits of being a homeowner, tight financing for new home development, and limited lot availability and other supply side issues. See Neil Irwin's excellent review of the issues. You can sum this up quickly by saying the contours of the housing market have changed dramatically in the past decade and we do not know when and if we will see a return to what in the past was considered a normal environment.

Moreover, the Fed can have little impact on these issues, with the exception of one factor not mentioned above - interest rates. The roughly 100bp rise in mortgage rates since the taper talk began likely contributed to the softening of housing markets. There was a lack of countervailing factors at play to offset the tighter policy (see also Jared Bernstein). The Fed, however, is not likely to reverse course. They want out of the asset purchase business, and higher mortgage rates was the price that needed to be paid. For now, the policy impact of housing weakness is to ensure the long-term, low rate story holds (all else equal, of course).

I have characterized the Fed's decision to taper as a desire to normalize policy by shifting attention back to their primary policy instrument of short-term interest rates. They believed at the time that they could change the mix of policies without changing the level of accommodation. The softening of housing activity, however, suggests otherwise. Intentionally or not, the decision to taper resulted in a somewhat more hawkish reaction function than is consistent with the Fed's economic forecast and policymaker rhetoric.

This leads to a comment recently posed to me:

I think governors will soon come under a lot of pressure to get off of the zero bound before the next recession hits. Given the big delay in monetary impulse-response, I fear some overshooting could result.

I frequently hear similar sentiments, but I don't think this is the correct way to phrase the issue. I think that policymakers want to be able to normalize policy further, but that ultimately the ability to do so depends on the evolution of the economy. In other words, the path of short-term interest rates is an endogenous variable determined within the context of the Fed's current reaction function. Policymakers realize they can't rush to normalize rates because doing so is counterproductive. Premature tightening will only ensure a low rate environment is sustained even longer. And note the Fed is emphasizing the low levels of rates in their forecast, explicitly acknowledging rates will remain below "normal" levels far into the future. No rush to hike rates.

The tapering adventure and the subsequent impact on mortgage rates and housing has probably driven this point home. Indeed, it could be argued that the recent flattening of the yield curve is an indication that the Fed already risked the ability to normalize policy by initiating the tapering process and signaling their rate hiking intentions:

They probably do not want to push this any further just yet.

That doesn't mean the Fed can't overshoot further on the tighter side, only that I suspect any such overshoot will be the result of a forecast error that prompts excessive tightening, not simply a desire to normalize rates. We aren't there yet. I think we could get there quickly given the Fed's relatively dovish outlook (if firmer data quickly mounted), but not yet.

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Fed Watch: FOMC Week

Tim Duy:

FOMC Week, by Tim Duy: The FOMC will wrap up a two-day meeting this Wednesday. I suspect the subsequent statement will be met with little fanfare. There simply has been little in the way of data to prompt any new policy path. Steady as she goes.

To be sure, the Fed will be greeted by the Q1 GDP report Wednesday morning, and it is widely expected to be very weak. But incoming data (retail sales, auto sales, industrial production, and employment, for example) suggests that much of this weakness was weather related while the underlying pace of activity, albeit arguably unexciting, remains unchanged. In short, the economy is evolving largely according to the Fed's script, and thus we should expect no major policy change. I anticipate the statement will reflect a greater confidence that the first quarter growth hiccup was a weather effect, that low inflation remains a concern, and a reiteration of the Fed's commitment to a low-rate policy path as long as inflation remains a concern. And another $10 billion cut in asset purchases to push the taper further along.

The Fed may identify housing as an area of concern. Indeed, the recent softening of that sector appears unrelated to the weather. Instead, a variety of issues are at play - higher housing prices in many areas, tight underwriting conditions, insufficient job growth, low wages relative to home prices, uncertainty about the financial benefits of being a homeowner, tight financing for new home development, and limited lot availability and other supply side issues. See Neil Irwin's excellent review of the issues. You can sum this up quickly by saying the contours of the housing market have changed dramatically in the past decade and we do not know when and if we will see a return to what in the past was considered a normal environment.

Moreover, the Fed can have little impact on these issues, with the exception of one factor not mentioned above - interest rates. The roughly 100bp rise in mortgage rates since the taper talk began likely contributed to the softening of housing markets. There was a lack of countervailing factors at play to offset the tighter policy (see also Jared Bernstein). The Fed, however, is not likely to reverse course. They want out of the asset purchase business, and higher mortgage rates was the price that needed to be paid. For now, the policy impact of housing weakness is to ensure the long-term, low rate story holds (all else equal, of course).

I have characterized the Fed's decision to taper as a desire to normalize policy by shifting attention back to their primary policy instrument of short-term interest rates. They believed at the time that they could change the mix of policies without changing the level of accommodation. The softening of housing activity, however, suggests otherwise. Intentionally or not, the decision to taper resulted in a somewhat more hawkish reaction function than is consistent with the Fed's economic forecast and policymaker rhetoric.

This leads to a comment recently posed to me:

I think governors will soon come under a lot of pressure to get off of the zero bound before the next recession hits. Given the big delay in monetary impulse-response, I fear some overshooting could result.

I frequently hear similar sentiments, but I don't think this is the correct way to phrase the issue. I think that policymakers want to be able to normalize policy further, but that ultimately the ability to do so depends on the evolution of the economy. In other words, the path of short-term interest rates is an endogenous variable determined within the context of the Fed's current reaction function. Policymakers realize they can't rush to normalize rates because doing so is counterproductive. Premature tightening will only ensure a low rate environment is sustained even longer. And note the Fed is emphasizing the low levels of rates in their forecast, explicitly acknowledging rates will remain below "normal" levels far into the future. No rush to hike rates.

The tapering adventure and the subsequent impact on mortgage rates and housing has probably driven this point home. Indeed, it could be argued that the recent flattening of the yield curve is an indication that the Fed already risked the ability to normalize policy by initiating the tapering process and signaling their rate hiking intentions:

They probably do not want to push this any further just yet.

That doesn't mean the Fed can't overshoot further on the tighter side, only that I suspect any such overshoot will be the result of a forecast error that prompts excessive tightening, not simply a desire to normalize rates. We aren't there yet. I think we could get there quickly given the Fed's relatively dovish outlook (if firmer data quickly mounted), but not yet.